Trading Ideas: Matter of Edge

One thing that a lot of students falter with during interviews is the trading idea. Im writing this post to help some of the monkeys currently preparing for interviews realize that what they are spewing out as trading ideas are instead sales pitches, and they should be presenting a trading plan to the interviewer instead. This will put you miles ahead of other candidates interviewing and show a bit of understanding of what it means to be a successful trader.

Trading is about edge, you need to have a statistical edge to make money over a longer stretch, otherwise you are gambling. Many students think they understand this but then go and applaud someone like Paulson or Lippman who put billions of dollars on the line on one idea. This type of balls to the wall isn't trading, but rather an all or nothing bet.

A feeling isn't an edge, a lot of the trade ideas that are sort of talked about on this site are based on the idea of some sort of absolute determination.

Philosophical rant over, when you are constructing your idea, make sure to be able to answer the following questions:

1)What is the edge on this trade? Why do you expect to make money?

Let's say company X earnings are being priced in at a 4% move (ie options have an implied vol that is pricing a vol of this magnitude). You look back and find that never has the stock of this company moved more than 2% post earnings, and there aren't any different factors now then other earnings. Therefore going short vol presents a simple form of edge. Now it is true that you are using historical information and extrapolating, but it is much better than telling the interviewer simply that:

"I think the earnings move priced into the options market is too rich"

2) What is your stop loss on this trade and why?

At what point do you get out of the trade? Let's say you went short gamma in the above example, and the stock starts to move heavily as the earnings announcement is moving closer, more than the implied vol you sold gamma at, what point do you decide to get out? (Its a bit simpler with straight stock compared to options because you only have price to look at in terms of a stop, whereas with options you can lose money in many more ways and therefore have to think about various scenarios).

When an interviewer asks this question go through a scenario analysis of situations that could make you lose money and then explain what you would do.

3) How do you get out of the position if it goes against you?

Do you get rid of all at once, in 2 or 3 stages or in small steps? Your answer should be about amount of liquidity, market conditions (ie whether your trade hypothesis has changed or not)

4) How long do you expect to hold the trade on for?

What you went long a stock because you have studied this stock and found that the probability of it being acquired is high, how long until you reverse this hypothesis? Note that holding time does not have to be in terms of days/months, but also in terms of relevant market conditions.

5) What are your main risks?

You want to think about a scenario analysis of possible situations that can make you lose money. Of course you cannot prepare for everything that can happen, but some prep is better than none. Let's say a stock is going to announce a drug test result and you see the following vol schedule (the drug announcement is at the begining of September and it is currently May):

June: 20% vol
September: 18% vol
December: 22% vol

You think the 18 vol is cheap and it should rise to at least 30% leading up to the event (or you think the event will be a large realized move in which case you are planning on making money on gamma, but we will stick with vega and implied vol in this example).
You might think about going short the June vol at 20 to fund the long vol position in the Sep contract to reduce the risk of losing money leading up to the announcement if nothing happens throughout June.

There might also be a strong correlation between vol of the stock and the S&P Index for example. If the drug announcement goes through this will affect the stock's vol but have a muted effect on the index vol, but you only expect the stock vol to drop if the index vol drops as well. In this case going short index vol as a hedge might be a good idea. The event in this case presents a case of a correlation break, and you want to take advantage of these.

Sorry for the long post but I think that these are important things missing from a lot of students trade ideas, and if you do incorporate some of these things you will have a much easier time standing out. I probably missed some things and if anything pops into my head I will add to it.

Comments (20)

11y
trade4size, what's your opinion? Comment below:

FANTASTIC! Everyone should read this and understand it completely.

So building on this concept of edge I propose a question to you. Does an edge always have to be directly quantifiable? As I mentioned in another post while I feel most of the time the market is random there are definitely situations where there are non random exploitable events such as the above mentioned potential idea. I feel like every situation is unique and some things you just cannot quantify or perhaps you lack the data itself to quantify it but your mind has noticed the pattern.

I work on a risk arb desk which is almost always considered to be primarily a qualitative strategy however I am in the process of researching ways to quantify certain aspects of deal analysis. I think often you can take qualitative ideas and convert them into something quantifiable but it will require making generalizations.

Example: Each tender offer is going to have its own set of circumstances but however they are all tender offers which as a group tend to have a certain profile given market conditions.

"Oh the ladies ever tell you that you look like a fucking optical illusion" - Frank Slaughtery 25th Hour.
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11y
derivstrading, what's your opinion? Comment below:

I think you've hit the nail on the head.

Personally, I am not a quant jockey, but I find that quantifiying helps to make things relative, and much easier to compare situations. In the end, P&L is a number, and therefore I find it natural to deal with numbers. Trading to me is about combining qualitative ideas and quantitative analysis.

To answer your question, I guess edge does not have to be something that in essence is quantitative, but imo you should be able to quantify it somehow, otherwise you have no idea if there is in fact an edge, if that makes any sense lol

Ive started reading up on risk arb, because i feel its these types of situations that are hard to quantify where an edge can be found, ie looking at implied probability of success in options markets versus the implied probability in the stock.

11y
trade4size, what's your opinion? Comment below:

Happy to discuss that at length with you in PM.

"Oh the ladies ever tell you that you look like a fucking optical illusion" - Frank Slaughtery 25th Hour.
11y
alexpasch, what's your opinion? Comment below:
derivstrading:
Many students think they understand this but then go and applaud someone like Paulson or Lippman who put billions of dollars on the line on one idea. This type of balls to the wall isn't trading, but rather an all or nothing bet.

I liked your post, but I think you are oversimplifying what they do/did. IMO, when you're a fund, it's definitely ok to make such a bet, as long as its a broad macro directional bet and not just "oh I'm buying a ton of options on stock X because it's undervalued". These are not quant funds and investors understand that, the investors want directional bets because otherwise the risk/return isn't there in those types of strategies. The investor is diversified, and even the fund manager won't have all of their wealth in the fund (though it will be substantial). What you're describing is a more quant style strategy, it's not any "better" than what Lippman, Paulson, and others like them do. It's just different. If I had a guy come in for an interview and tell me he wanted to go "balls to wall" on one investment thesis, I think that sounds just as impressive, IF he can back up his logic and give me an idea of how he's going to manage risk given that it all revolves around one theme. It all depends on what the firm does which candidate is a better fit.

11y
derivstrading, what's your opinion? Comment below:
alexpasch:

I liked your post, but I think you are oversimplifying what they do/did. IMO, when you're a fund, it's definitely ok to make such a bet, as long as its a broad macro directional bet and not just "oh I'm buying a ton of options on stock X because it's undervalued". These are not quant funds and investors understand that, the investors want directional bets because otherwise the risk/return isn't there in those types of strategies. The investor is diversified, and even the fund manager won't have all of their wealth in the fund (though it will be substantial). What you're describing is a more quant style strategy, it's not any "better" than what Lippman, Paulson, and others like them do. It's just different. If I had a guy come in for an interview and tell me he wanted to go "balls to wall" on one investment thesis, I think that sounds just as impressive, IF he can back up his logic and give me an idea of how he's going to manage risk given that it all revolves around one theme. It all depends on what the firm does which candidate is a better fit.

The main idea I was trying to express is that you should never go all in unless you are 100% that you have the best hand (or if the blinds are huge and you are a tiny stack but lets forget about that for a sec).

As Larry Hite said: You need to play the game to win, and if you lose it all you can't play

Maybe these guys thought that they had the best hand, the Royal Flush, and therefore felt appropriate to do that. I wasn't knocking what they did, but more the perception it gives of trading with large size relative to what's backing you.

Whats important to remember is that with a limited bankroll high variance will easily wipe you out (as any poker player knows)

A simple example shows the downfall of full using a full bankroll:

If you start with 100: Gain of 50% then loss of 50% = 75 (25% loss) Loss of 50% then gain of 50% = 75 (25% loss)

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11y
trade4size, what's your opinion? Comment below:

Had a friend that was an engineering major at northeastern, the kid went into an informational interview with a presentation which was basically a couple charts and a series of bullets points behind his idea along with the normal resume. His thesis was basically that the market was about to experience a swift move lower that was lead by banks. This was just a few weeks after Bear collapsed. The people he gave the presentation from what he told me were not even up to snuff with what he was talking about. The next day he had an interview with a department head but nothing ever came of it. Just anecdotal thought i would share.

"Oh the ladies ever tell you that you look like a fucking optical illusion" - Frank Slaughtery 25th Hour.
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11y
alexpasch, what's your opinion? Comment below:
trade4size:
Had a friend that was an engineering major at northeastern, the kid went into an informational interview with a presentation which was basically a couple charts and a series of bullets points behind his idea along with the normal resume. His thesis was basically that the market was about to experience a swift move lower that was lead by banks. This was just a few weeks after Bear collapsed. The people he gave the presentation from what he told me were not even up to snuff with what he was talking about. The next day he had an interview with a department head but nothing ever came of it. Just anecdotal thought i would share.

That's sad, I can relate in a way (though not about subprime, I did short financials but not big time, and def wasn't pitching that to anyone).

11y
northeast1, what's your opinion? Comment below:

According to most academics you can't have an edge due to EMH unless you are either a market maker with a seat or corrupt. Manipulation and other scams could be thought of as an edge in an efficient market.
Other than that the markets are mostly random and all players will eventually go bust in the end. Word to the wise: ALL "risk taking" is really gambling since we cannot calculate odds outside of a casino. That is, unless you have the game rigged in your favor (or you're working for a bonus with no clawbacks, then none of this shit matters).

Best Response
11y
derivstrading, what's your opinion? Comment below:
northeast1:
According to most academics you can't have an edge due to EMH unless you are either a market maker with a seat or corrupt. Manipulation and other scams could be thought of as an edge in an efficient market.
Other than that the markets are mostly random and all players will eventually go bust in the end. Word to the wise: ALL "risk taking" is really gambling since we cannot calculate odds outside of a casino. That is, unless you have the game rigged in your favor (or you're working for a bonus with no clawbacks, then none of this shit matters).

That is why academics are poor as shit.

On a side note, in BB Cash Equities a market maker actually loses money on average with risk trades. Their goal is to lose less on risk trades than they get paid in commissions and prime brokerage fees.

11y
kobalt, what's your opinion? Comment below:
northeast1:
According to most academics you can't have an edge due to EMH unless you are either a market maker with a seat or corrupt. Manipulation and other scams could be thought of as an edge in an efficient market.
Other than that the markets are mostly random and all players will eventually go bust in the end. Word to the wise: ALL "risk taking" is really gambling since we cannot calculate odds outside of a casino. That is, unless you have the game rigged in your favor (or you're working for a bonus with no clawbacks, then none of this shit matters).

I think it's slightly different from some of the professors I've spoken to. The basic premise is that the average fund manager and investor is not going to beat the market on a consistent basis. However, if your strategy is advanced and different from others you can beat the market, that is until others discover your winning strategy and the abnormal profit opportunity disappears. But overall the EMH is semi-strong with several noted exceptions (e.g., price momentum, January effect, excessive volatility, etc.).

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11y
alexpasch, what's your opinion? Comment below:
Bondarb:
The Subprime example is a tuff one because the optionality on the trades lippman and paulsen were doing was so ridiculous. If the World hadnt collapsed they wouldnt have "lost it all" because the market was priced for perfection.

Exactly, I guess that would be the equivalent of the "Royal Flush" analogy he alluded to. It's ok to bet a significant amount on one thing if you are very confident and know there is minimal downside risk.

11y
marcellus_wallace, what's your opinion? Comment below:

Lippman who stole Burry's trade and backed with Eisman's research. Won big time... But the trade was still profitable even if subprime defaulted slightly and was against the very very worse shit. Plus they all had an edge in it, that they were the only ones who understand wtf a CDO of MBS really is and how it was created.

So I think that scenario, they all for sure had an edge.

11y
yesman, what's your opinion? Comment below:

@derivstrading - this is a great post. In general, prospective traders on WSO need to learn to differentiate between an investing role and a trading role. You are wise to highlight the need for 'edge' - a lot of guys think that profit at a BB comes from making your spread, but in more often than not, it comes from properly anticipating a short-term price fluctuation and hedging a position to profit accordingly (ie - managing exposure). After years of trading successfully via screen, Nassim Taleb decided to learn the true nature of price origination by entering the pits. It took him - a seasoned options market maker - nearly 18 months to trade proficiently and he eventually came to this conclusion (spikes v. spreads).

@trade4size - I completely agree with you on the need to employ a qualitative approach to risk management. Quants / black box are certainly the zeitgeist, but I've seen plenty of PhD quant jocks go bust. I think trading successfully requires a common sense / emotional intellect that evades many.

@northeast1 - Traders don't believe in EMH; it is the result of the over-quantification of markets. Bankers don't really believe in it either. The financial sector as a whole would not be as profitable as a %GDP if markets were efficient. Innovation in technology (eg - the move from pit to screen trading) can make markets operate more efficiently, but markets aren't efficient. You'd be wise to view the EMH as a theoretical starting point for understanding markets - learn the rules so you can break them properly, per se.

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11y
GotBushels, what's your opinion? Comment below:

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